Whether to buy a house and pay EMI or earn more from markets

Records collated by India’s largest housing finance company HDFC shows that salary levels over the last decade has outpaced the rate at which house prices has increased in the top cities in India. There is enough left in the hands of professionals to either splurge or save. Thankfully the wiser ones believe in saving.

This has now risen to a paradox of plenty. This problem of plenty is undoubtedly a better situation to be in rather than one where resources are scarce. The problem is of buying a house and paying hefty equal monthly installments (EMI) or to smartly invest in equity markets which can give higher returns.

Like all good problems this one too does not have an easy solution.

Many youngsters, few years into their jobs manage to save enough to cough out the minimum payment required to buy a house. But the issue here is whether buying a house is an investment or one where the person plans to live.

Before getting in the intricacies lets first look at the basic problem which is – does it makes sense to invest in a house and pay EMI on the remaining money or to invest the money wisely and earn returns at a faster pace than the appreciation of the house.

Property prices have historically increased at a rate of 10-15 percent per annum while investment, even in the broad market indices has given a return of 17 percent. It is a no brainer then that investing in equities would make more sense.

However, the solution is not that simple. As pointed out earlier one needs to consider the utility of investment in a housing property. Another factor that adds a twist to the decision is whether the property under consideration is readily available or will take more time before possession is given.

So we have four situations in front of us. First is buying a house for investment purpose which is ready, second is buying a under construction house for investment purpose. Third is buying a ready house to move in and fourth is buying a under construction house where the person intends to stay in future.

Before looking at the four scenarios one common factor that needs to be taken into consideration, especially when we are comparing it against investment in equities, is that of taxes. In equities, gain on long term investment is tax free while in short term it is taxable.

However, government has over the years encouraged investment in housing and has given various rebates and benefits. A deduction on the principal amount up to Rs 150,000 is allowed every year and a deduction of interest up to Rs 200,000 is permissible as per the government of India. These deductions need to be taken into account when comparing the two asset classes.

The cost of acquiring the asset or effective interest paid for buying the house comes down due to the tax benefit. To add to that is the leverage advantage that a house owner gets.

Let’s take a case of a house which is being bought for Rs 1 crore with the individual making a down payment of Rs 25 lakh. Thus Rs 75 lakh has been financed by the bank at 9 percent to be repaid 20 years. Now in two years the value of the house is Rs 1.20 crore at which point the individual decides to sell the house and pocket the profit.

The money that the individual will receive in his hand after paying off all pending bank loans will be Rs 1.20 crore minus pending principal amount. To calculate the return on investment of the individual one needs to add the initial capital plus the EMIs paid over two years and deduct the tax benefits availed during this period.

Since housing loans are front loaded where the individual pays higher interest in the initial years and lower principal, the person would end up claiming the entire Rs 2 lakh interest deduction benefit in both years and barely the entire principal amount on the Rs 75 lakh loan. EMI Calculator gives the yearly breakup of principal and interest on a Rs 75 lakh loan at 9 percent for 20 years.

Thus the tax benefits that has accrued to the individual is to the tune of Rs 7 lakh over two years while total EMI paid over this period is Rs 16.19 lakh. Net cost after deducting the benefit for the individual is Rs 35.19 lakh. After he repays the loan amount the individual is left with Rs 48 lakh (Rs 28 lakh investment including two years of principal payment and Rs 20 lakh as profit). Absolute gain over two year is 36.38 percent which will however be taxable.

Now let’s consider the four cases.

In the first case where the individual has bought the property as an investment there is a scope of additional income in the form rent, which also is now taxable in India. The rent amount has to be added to derive the investment yield of buying a house over equities. The benefit here is that rents generally increase between 5-10 percent every year which will improve the long term yield.

In the second case where investment is made in an under construction property since the house is not ready, there will not be any rental yields and thus there will be lower return from this investment.

In the third case where the person intends to stay in the house there will be no rental income but at the same time he would not have to pay rent for his present residence. This saving will have to be considered in making an investment decision.

Finally, a person who intends to buy an under construction property will have to continue to pay rent for his present residence as well as EMI of the future residence till he gets access to the property.

Clearly the decision to choose between the two asset classes – house property versus equity investment is not an easy one given complexity of taxes involved and the uncertainty of market forces both in equities and real estate.